Systemic Risk in Ten Stocks?

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CFK
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Systemic Risk in Ten Stocks?

Post by CFK » Mon Feb 26, 2018 7:57 pm

One thing that bothered me is that during the recent stock market nosedive, stocks seemed to move largely in line with one another. A second is that the DJIA - which has only thirty stocks - basically mirrors the returns of the SP 500. This is so even though many people on this board swear by the total stock market "because it has 3000+ stocks, instead of just the 500 you'd get in SP500." Do those extra 2500 stocks really add any diversification? Or are you already taking on only system risk. The third is that I read that you only have to invest in a dozen or so large cap stocks, and you've already basically eliminated or greatly reduced the risks associated with individual securities. I'm not sure I believe the last point, but hey, the internet never lies.

So with that introduction, I decided to create my own CFK 10 on investopedia. I created a second game that invests in the SP 500.

The CFK 10 is made up of equal weighting of the following:

Bank of America
Archer Daniel Midlands
Lockheed Martin
Texas Instruments
Gilead Sciences
Eli Lilly
Costco
Morgan Stanley
Colgate Palmolive
Starbucks

My criteria were: large cap stock, profitable at least 4 of last 5 years, I've heard of them, not included in the Dow Jones Industrial Average (just to make it a little bit more interesting), not concentrated in one industry. I will remove a stock only if it becomes unprofitable two years in a row (I plan to keep this open indefinitely). I am not going to rebalance.

My question is: to what extent do you think this would mirror the SP 500, or DJIA? Can "stock pickers" effectively create their own investment list that is likely to match the market's returns? And if so, can they do it with as few as ten stocks?

My prediction is that this will probably match the market's returns over a long enough period of time, but will have greater volatility.

Curious to hear your responses, or what stocks you'd pick if your goal was to mirror the broader market.

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David Jay
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Re: Systemic Risk in Ten Stocks?

Post by David Jay » Mon Feb 26, 2018 8:01 pm

1. 10 stocks is not enough to diversify away unsystematic risk. You likely need 30-50.
2. Equal weight will create tracking error over time.
Prediction is very difficult, especially about the future - Niels Bohr | To get the "risk premium", you really do have to take the risk - nisiprius

AlohaJoe
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Re: Systemic Risk in Ten Stocks?

Post by AlohaJoe » Mon Feb 26, 2018 8:06 pm

CFK wrote:
Mon Feb 26, 2018 7:57 pm
My prediction is that this will probably match the market's returns over a long enough period of time, but will have greater volatility.
See below in the thread for why this was wrong :oops:

Over the past 14 years (for some reason PortfolioVisualizer only has Morgan Stanley back until March 1993) your CFK 10 has been destroyed by the S&P 500. (And remember that includes two major crashes -- 2000 & 2008 -- a decade of no returns and a bull market, so we're unlikely doing significant cherry picking.)

The difference between $100,000 (your stock picking) and $500,000 (Bogleheads indexing) is....significant.

Image
Last edited by AlohaJoe on Mon Feb 26, 2018 9:27 pm, edited 1 time in total.

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whodidntante
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Re: Systemic Risk in Ten Stocks?

Post by whodidntante » Mon Feb 26, 2018 8:15 pm

CFK wrote:
Mon Feb 26, 2018 7:57 pm
One thing that bothered me is that during the recent stock market nosedive, stocks seemed to move largely in line with one another. A second is that the DJIA - which has only thirty stocks - basically mirrors the returns of the SP 500. This is so even though many people on this board swear by the total stock market "because it has 3000+ stocks, instead of just the 500 you'd get in SP500." Do those extra 2500 stocks really add any diversification? Or are you already taking on only system risk.
Yes, those extra stocks do increase diversification. However, diversification doesn't mean "loss prevention." Down markets are fearful markets, and it's pretty rare to be an up stock in a down market. Just like people waste their money buying Snap in an up market.

It's conceivable that we could have a political, cultural, or economic environment that would strongly favor a certain segment of the market. For example, like we do now and usually do. TSM guarantees you have the winners, but just at market weight. No bragging. Plus when other people talk about a public company you can say you have shares in it.

Twelve stocks is much more diversified than one stock particularly if they are spread across sectors, factors, and nations. If I buy a number equivalent to my fingers and toes, that would be somewhat better.

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bottlecap
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Re: Systemic Risk in Ten Stocks?

Post by bottlecap » Mon Feb 26, 2018 8:19 pm

If you were interested, the numbers are out there.

What do the numbers say? Yes, 3,500 stocks gives greater diversification benefits, but the benefits are incrementally smaller after about 100.

As with any straw man argument, it is wrong. People don’t say "invest in the total market because it has 3,000 stocks instead of 500." People say that it has small and mid cap and that it is inexpensive. They readily acknowledge that you can tax loss harvest it with the S&p 500 and maintain about the same risk.

I don’t know why you'd want to do a meaningless experiment with 10 stocks when there are likely hundreds of studies on the topic.

But good luck anyway.

JT

RRAAYY3
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Re: Systemic Risk in Ten Stocks?

Post by RRAAYY3 » Mon Feb 26, 2018 8:43 pm

It really is mind blowing the lengths people will go to overcomplicate things.

Impressive

CFK
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Re: Systemic Risk in Ten Stocks?

Post by CFK » Mon Feb 26, 2018 8:47 pm

AlohaJoe wrote:
Mon Feb 26, 2018 8:06 pm
CFK wrote:
Mon Feb 26, 2018 7:57 pm
My prediction is that this will probably match the market's returns over a long enough period of time, but will have greater volatility.
Over the past 14 years (for some reason PortfolioVisualizer only has Morgan Stanley back until March 1993) your CFK 10 has been destroyed by the S&P 500. (And remember that includes two major crashes -- 2000 & 2008 -- a decade of no returns and a bull market, so we're unlikely doing significant cherry picking.)

The difference between $100,000 (your stock picking) and $500,000 (Bogleheads indexing) is....significant.

Image
I would look at that again, because I think you switched the SP 500 and the portfolio I offered.

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nisiprius
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Re: Systemic Risk in Ten Stocks?

Post by nisiprius » Mon Feb 26, 2018 9:05 pm

First, read The Fifteen-Stock Diversification Myth, by William J. Bernstein. It makes an interesting and non-obvious point. The reason you want to have many stocks, and if possible the whole market, is because of an issue unrelated to standard deviation:
The reason is simple: a grossly disproportionate fraction of the total return came from a very few "superstocks" like Dell Computer, which increased in value over 550 times. If you didn’t have one of the half-dozen or so of these in your portfolio, then you badly lagged the market.
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.

Wagnerjb
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Re: Systemic Risk in Ten Stocks?

Post by Wagnerjb » Mon Feb 26, 2018 9:09 pm

CFK wrote:
Mon Feb 26, 2018 7:57 pm

My prediction is that this will probably match the market's returns over a long enough period of time, but will have greater volatility.
I think that is a very reasonable expectation, although I would personally have closer to 30 stocks if possible. Here is an article that demonstrates the kind of higher volatility you can expect:

http://ppca-inc.com/pdf/DiversByNumbers.pdf

For what its worth - I held a portfolio of roughly 30 large cap stocks for 15+ years (before I retired and began winding them down), and my experience matched the Surz Price article very closely. My portfolio essentially matched the S&P500 over that time period, but with greater volatility.

Keep in mind that a large cap portfolio such as yours should be benchmarked against the S&P500 or similar. It is much more difficult to replicate the small cap returns with an individual stock portfolio due to the presence of a few huge winners in this space. For that reason, I firmly believe in using low-cost diversified passive mutual funds for small caps (and international too).

Best wishes.
Andy

raisinsaregrapes
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Re: Systemic Risk in Ten Stocks?

Post by raisinsaregrapes » Mon Feb 26, 2018 9:10 pm

If you would have done this 15 years ago Dell would have probably been in that top 10. Instead of Morgan you may have gone with Lehman Brothers. Who knows what these next 15 years has in store.

AlohaJoe
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Re: Systemic Risk in Ten Stocks?

Post by AlohaJoe » Mon Feb 26, 2018 9:26 pm

CFK wrote:
Mon Feb 26, 2018 8:47 pm
AlohaJoe wrote:
Mon Feb 26, 2018 8:06 pm
CFK wrote:
Mon Feb 26, 2018 7:57 pm
My prediction is that this will probably match the market's returns over a long enough period of time, but will have greater volatility.
Over the past 14 years (for some reason PortfolioVisualizer only has Morgan Stanley back until March 1993) your CFK 10 has been destroyed by the S&P 500. (And remember that includes two major crashes -- 2000 & 2008 -- a decade of no returns and a bull market, so we're unlikely doing significant cherry picking.)

The difference between $100,000 (your stock picking) and $500,000 (Bogleheads indexing) is....significant.
I would look at that again, because I think you switched the SP 500 and the portfolio I offered.
Indeed, I am an idiot! (Unfortunately not the first time I've discovered that.) I've updated my post to reflect that sad fact.

I am glad, though, that we are both in agreement that the returns won't match.

iamthewalrus
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Re: Systemic Risk in Ten Stocks?

Post by iamthewalrus » Mon Feb 26, 2018 9:49 pm

All three of your implied answers have some degree of truth to them.

Another way of looking at it is that the top 10 components of the S&P 500 comprise around 21.75% of the index, over 1/5th in just 2% of the companies in the index. The top 3 are almost 10% by themselves. The final 10% of the index is over 200 companies, so each incremental holding has less and less of an impact on the overall index as to be almost meaningless.

For the typical passive investor in a tax advantaged account a broad based market index is absolutely the best choice, but a well constructed basket of stocks, as you picked, for example, diversified across industries and selecting high quality companies (by looking at profitability), should absolutely be competitive with an index and will diversify the vast majority of the systematic risk.

bpp
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Re: Systemic Risk in Ten Stocks?

Post by bpp » Mon Feb 26, 2018 10:32 pm

CFK wrote:
Mon Feb 26, 2018 7:57 pm
Can "stock pickers" effectively create their own investment list that is likely to match the market's returns? And if so, can they do it with as few as ten stocks?
The following wiki page summarizes some studies on this issue: Passively managing individual stocks

TLDR: Probably want more than 10 stocks, probably don't need as many as 100.

While the discussion there generally assumes randomly-chosen stocks, I would argue that in an efficient market, the results of "stock picking" should be the same as random selection, after accounting for any factor loading (size, value, etc.) that may occur either intentionally or not.

stlutz
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Re: Systemic Risk in Ten Stocks?

Post by stlutz » Tue Feb 27, 2018 1:17 am

One interesting comparison that is worth looking at would be to the Corporate Leaders Trust (LEXCX). This UIT back in the 30s with an equal holding in 30 stocks. Holdings only change due to merger, acquisition or spin-off. The interesting thing is how close the performance has been to the S&P 500 over the decades.

Valuethinker
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Re: Systemic Risk in Ten Stocks?

Post by Valuethinker » Tue Feb 27, 2018 6:01 am

CFK wrote:
Mon Feb 26, 2018 7:57 pm
One thing that bothered me is that during the recent stock market nosedive, stocks seemed to move largely in line with one another. A second is that the DJIA - which has only thirty stocks - basically mirrors the returns of the SP 500. This is so even though many people on this board swear by the total stock market "because it has 3000+ stocks, instead of just the 500 you'd get in SP500." Do those extra 2500 stocks really add any diversification? Or are you already taking on only system risk. The third is that I read that you only have to invest in a dozen or so large cap stocks, and you've already basically eliminated or greatly reduced the risks associated with individual securities. I'm not sure I believe the last point, but hey, the internet never lies.

So with that introduction, I decided to create my own CFK 10 on investopedia. I created a second game that invests in the SP 500.

The CFK 10 is made up of equal weighting of the following:

Bank of America
Archer Daniel Midlands
Lockheed Martin
Texas Instruments
Gilead Sciences
Eli Lilly
Costco
Morgan Stanley
Colgate Palmolive
Starbucks

My criteria were: large cap stock, profitable at least 4 of last 5 years, I've heard of them, not included in the Dow Jones Industrial Average (just to make it a little bit more interesting), not concentrated in one industry. I will remove a stock only if it becomes unprofitable two years in a row (I plan to keep this open indefinitely). I am not going to rebalance.

My question is: to what extent do you think this would mirror the SP 500, or DJIA? Can "stock pickers" effectively create their own investment list that is likely to match the market's returns? And if so, can they do it with as few as ten stocks?

My prediction is that this will probably match the market's returns over a long enough period of time, but will have greater volatility.

Curious to hear your responses, or what stocks you'd pick if your goal was to mirror the broader market.
Given there is no FAANG in there you would have underperformed by quite a bit in recent times, I believe.

The problem is so much of the performance of the S&P500 is now a very few companies. The FAANG phenomenon is perhaps extreme, but by no means unique.

As an analogy consider my investments in the FTSE All-Share index in London. Way underperformed the US, because the London index is heavy in oil & gas (Shell & BP), tobacco, pharma, banks, mobile (Vodafone) but has almost no tech.

My "stock selection" by holding that 8% or so of world markets vs. your 50%+ in the S&P500 has been very poor.

Valuethinker
Posts: 36718
Joined: Fri May 11, 2007 11:07 am

Re: Systemic Risk in Ten Stocks?

Post by Valuethinker » Tue Feb 27, 2018 6:03 am

raisinsaregrapes wrote:
Mon Feb 26, 2018 9:10 pm
If you would have done this 15 years ago Dell would have probably been in that top 10. Instead of Morgan you may have gone with Lehman Brothers. Who knows what these next 15 years has in store.
The point is absolutely correct.

But even at a less extreme pick: Goldman Sachs has, I believe, underperformed Morgan Stanley. Intel and Cisco have underperformed Apple. Who would have believed that?

For a retailer you might well have picked WalMart (15 years ago, by a wide margin, seen as the world's best retailer (of those publicly listed)) rather than Costco or Inditex (Zara).

Go back 20 years, you probably would have included Enron (the world's most admired company and "the utility of the future"), and maybe Worldcom. Nortel? (the world's largest telecommunications equipment maker, by market cap, at one point, I believe).

The impact of one bankruptcy with 10% in one stock (or even 5%) would be to really hurt performance.

CFK
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Re: Systemic Risk in Ten Stocks?

Post by CFK » Tue Feb 27, 2018 8:05 pm

bpp wrote:
Mon Feb 26, 2018 10:32 pm
CFK wrote:
Mon Feb 26, 2018 7:57 pm
Can "stock pickers" effectively create their own investment list that is likely to match the market's returns? And if so, can they do it with as few as ten stocks?
The following wiki page summarizes some studies on this issue: Passively managing individual stocks

TLDR: Probably want more than 10 stocks, probably don't need as many as 100.
Thanks to those who posted links to articles. I had thought I'd read the entire wiki - not only had I not read the whole thing, but there was an entire page dedicated to this question! Thanks for linking to it! Having read the materials, I think I'll keep my stock-picking to play money at investopedia.

anoop
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Re: Systemic Risk in Ten Stocks?

Post by anoop » Wed Feb 28, 2018 1:36 am

I asked a similar question back in 2016:
viewtopic.php?t=205142

You might find that discussion useful.

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